Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company The Guns of August
“In the summertime, when the weather is hot, you can stretch right up and touch the sky." - Mungo Jerry, In the Summertime
As we head into the final weeks of the silly season, certain targets loom. 10,000 on the Dow. Seventy-five dollars a barrel on oil. 1200 on the S&P 500, and the biggest bonus pools ever.
The attraction of these targets is mighty. They are acting as magnets to certain traders who, although perhaps not united in their beliefs about where profits are headed, are united in a belief that more profits lay in pushing the market higher, at least for a little while longer.
The irony of it all is that the parties concerned would be better off not reaching any of these targets, however much they would like to do so. We say this because of the old axiom that bad practices invite bad rules. Thus, despite the disasters of last year and a public that is only one more car wreck away from demanding that all and sundry be put in the stocks and left there to rot, the game goes on as if nothing ever happened.
Not all believe in it, of course. Many managers (including this one) believe that the S&P passed fair value some time ago, and some prominent market strategists have been handing out warnings. But market levels aren’t set by intelligent consultation, and in late summer, intelligence tends not to enter the picture at all. A good example of an oxymoron would be, “intelligent momentum market.”
The economy, as we make plain below, is doing nothing that can sustain current valuations. Yes, we’ve read the recent headlines, but they are being generated not by the underlying economic reality, but by the price action in the markets. People often make the mistake of assuming that market prices follow the news, but it is more often the case that price movements decide the tilt of the headline.
The structure of half-truths, wishful thinking and good old greed that the market rise rests upon is already rickety enough. The higher we go, the more likely the collapse. If market participants and corporate officers insist upon trying to go back to 2006 again, the wave of public revulsion that will follow is going to bring about retaliation in the areas of market regulation and compensation. We would rather not see more bad rules come to pass, but they tend to follow in the wake of greed that cannot seem to check itself.
As for the maxim that the market turns before the economy does, we agree. The problem is that the market has already priced in the turn, and it isn’t coming any time soon to a theater near you.
News from the Fed came that only thirty percent of banks surveyed tightened lending standards in July, as opposed to 40% in the April survey. Many tried to package this as good news, but we don’t buy it. In the first place, it doesn’t mean that banks are lending again, and in the second, the percentage of banks tightening standards falls naturally, because one cannot turn the dial past off.
The obvious bad news in the reports was that banks cited decreasing loan demand and weaker credit quality amongst their client base. Credit is not moving, and the banks have already tightened so much that weaker credit quality has become a tautology from the bank’s perspective. Client credit gets more suspicious every month, and that goes for Warren Buffett and Berkshire Hathaway, too.
No doubt this lack of credit flow played a role in the Fed’s decision to extend the TALF, which is helping the asset-backed securities market to function. Loan spreads (in other words, the mark-up to borrowers) were still widening for firms both large (60%) and small (65%). This occurred during a period when corporate bond spreads were narrowing, a reflection that there has been heavy investor demand for corporate bonds, while the syndicated and leveraged-loan market is still moribund.
In other words, banks still aren’t lending and borrowers aren’t borrowing. The “unanimous” reason the banks gave for weaker demand was that customers had decreased financing needs for plant and equipment. Ergo, consumers aren’t spending, businesses aren’t investing and we’re sitting in a stagnant pond. That is definitely better than the maelstrom we had from last September through March, but it isn’t worth the twenty-eight times earnings that the market is trading at, either.
News also came from Fed Chairman Bernanke, but it probably wasn’t the part you read about, the bit about how hopeful he is about the recovery. As far as that goes, Chairmen Ben largely repeated the FOMC’s committee statement of the week before, the professional cautiously optimistic view that is the stock-in-trade of any central banker. The real news was that Ben reaffirmed how slow it’s going to be: “the recovery is likely to be relatively slow at first.” That is not a sunny outlook from a Fed chairman. Had Greenspan said it, markets would have fallen.
One problem that remains is how the markets can correct when traders everywhere are talking a ten percent downward move, or a big fall correction. One answer would be for the markets to keep soaring, for nothing generates a big drop like crushed hopes.
Yet perhaps we will do nothing: CNBC discussed the possibility put forth by Doug Kass (and echoed by Robert Shiller) that we are in for an extended period of the markets not really doing anything. Such a market characterized the middle of 1983 to the end of 1984. It was the period of the post-recession exit, had lots of ups and downs of less than ten percent (with one serious fade) and finished exactly where it started.
We can imagine such a scenario, but with larger ups and downs than the markets of the early eighties. After all, we didn’t come up with all of that financial innovation for nothing.
We finally, finally got some sideways-to-positive movement in the business activity surveys. Although the first tidbit from the New York Fed did nothing to succor the market on its Shanghai-frightened day, Thursday’s traders were feeling much more jovial and welcomed the Philadelphia survey with cheerful headlines and open checkbooks.
From New York came the announcement of a rise to 12.08 (versus consensus estimates of 5.0), with increases in new orders and shipments. The report also showed a slowing pace of inventory destocking and layoffs. For its part, the Philadelphia report showed an increase of 4.2 versus a consensus estimate of (- 1.0). Talk about stacking the deck – did anybody really believe it would be that low? New orders showed marginal improvement and shipments were virtually unchanged, but employment weakened.
Since the Philly report is thought to be a better indicator of where the national ISM manufacturing report comes out, due the week after next (along with the non-manufacturing report), there is much excited bubble, er, babble, about the ISM finally cresting 50. At which point, one imagines, all of our problems are over and it is simply a matter of pouring money into the highest-beta sectors as the economy roars along.
If only it were so simple. The surveys don’t report absolute levels of activity, only changes relative to the previous month. Back in the first week of June, we fretted that a rebound in manufacturing was already past due and compared the improvement to a change in batting average from .150 to .160. We reckon now that it’s about .180. In other words, it still stinks, but the day-traders are extrapolating the percentage change to All-Star levels. Try selling that to the manager sometime.
Back in the dark days of March, we wrote that the black hole of production cuts being priced in by the market was an illusion. Stuff runs out, and eventually the surveys would have to return to neutral-to-positive levels because production simply can’t go down every month, not unless we get some kind of meteor impact. Although the market has been anticipating this development for months, it looks ready to burst with amazed joy now that it is finally upon us. Such is the fabric of the momentum trader.
We don’t see any indications in the underlying economy that the bounce will be anything other than the short-lived bounce we’ve been predicting - along with our view that the market would overreact when it arrived.
An excellent example of the divergence between the soaring momentum narrative and the underlying flatness of the economy is the housing market. Representative of what one read were such items as “single family home construction reported a fifth straight monthly rise” and, “single-family-home starts remained strong,” from the Wall Street Journal’s coverage of the report on July housing starts.
What you didn’t read was that it was the single worst July ever for housing starts and single-family starts, at least in the fifty years that the government has kept records. Yes, we checked. According to data that goes back to 1959, no July has ever produced fewer starts in either category.
One could also read, courtesy of the Financial Times, that the homebuilder index “swelled in August” and has “more than doubled” since the beginning of the year. Every publication carried the news that it was the strongest it’s been in over a year.
What you didn’t read (until now) was that the index rose exactly one point from the month before, or that it’s precisely two points higher than one year ago, or that the index of current sales conditions is unchanged (hopes for future sales added the point), or that the index is forty percent lower than any time in 2006, less than one-third of the levels reached in the last recession and lower than anytime in the 1990-1992 recession.
Very few bothered to note either that the actual number was eighteen, while a neutral reading is a very far-off fifty. There was some swelling going on all right, but it wasn’t in homebuilder sentiment.
The illusion of a rebounding housing market was rounded out by Friday’s existing home-sales report for July. One could read that the monthly change “is a spectacular 7.2%, the strongest jump in ten years,” a quote that comes from Fidelity but could have just as easily come from the Journal or a hundred other publications. If only it were true. Even if it were, it would have only been a façade.
In our last report on existing home sales, we wrote that the National Association of Realtors (NAR) is trumpeting inflated numbers every month that are then quietly revised downward the following month. Last month’s report, for example, was widely reported to be a better-than-expected run rate of 4.89 million homes versus the expectations for 4.85. It turns out that the run rate was exactly 4.85, not better than expected and worse than our revision guess of 4.86, but the market isn’t going to give that headline back.
Using the NAR’s as-announced numbers, the existing home sales rate rose 9.2% in the second quarter, a rate that is nearly forty percent higher than the actual increase of only 6.6%. But wait, you may say, then July’s increase (7.2%) was greater than the entire second quarter, surely that is good news? It would help if it were true, but the 7.2% figure will disappear next month, just like last month’s “better-than-expected.” That 7.2 is inflated by comparing a number yet to be revised lower with one that has been revised lower, a little sleight-of-hand that the NAR has been pulling every month of late.
There are some other problems. Not seasonally adjusted, sales rose only 2.1%. Yet July usually shows a rise, as it did last year when sales were reported to have risen 3.6% to “the highest level in five months” (and the rate for June 2008 was revised back down to 4.85 million units, the exact same rate as June 2009). At that time, the report spoke of hopes for a “sustained sales uptrend in the months ahead” and urged buyers to get off the sidelines.
We will allow that July 2009 totals are almost five percent higher than one year ago (itself revised upward before finally revised downward from the original report). Yet this is with prices having fallen an additional fifteen percent, mortgage rates 120 basis points lower, and a generous first-time homebuyer tax credit being added to the picture. Thirty percent of July sales were first-time homebuyers, and that credit’s effective expiration date is nearly here. It’s possible that the credit will be extended, but for now the knowledge that it’s about to expire is acting as a stimulus to buyers who want to get in before the door closes.
Thirty percent of July 2009 sales were foreclosures. Sixteen percent were all-cash offers, a rate that is fifty percent higher than average and probably speaks to the difficulty in getting a mortgage. The mortgage purchase application index is no longer being published and percentage changes are now reported instead, doubtless to improve transparency and accuracy of comparison, but our imputed index results show that application levels are still in the basement and below levels touched in June or July.
The fact is that housing sales are still sitting on the bottom, while the housing market itself is still sinking. July’s year-on-year decline of fifteen percent compared to a decline of seven percent the previous year, when an additional fifteen percent drop was unimaginable to most market participants.
Although comparisons are bound to improve, prices are nevertheless still declining. The Mortgage Banker’s Association reported on Thursday that one in eight homes are now in foreclosure or behind on payments. That particular group expects foreclosures to continue to rise, and noted that the delinquency rate for prime mortgages has nearly doubled over the last year, with primes now accounting for 58% of foreclosure notices. We don’t know how much more improvement like this the housing market can take.
How much more wealth destruction can the consumer take? Banking analyst Meredith Whitney, who helped trigger the summer rally by allowing that the financials would report decent earnings (of dubious quality, but that latter aspect was quickly overlooked), estimated that three times as many banks are yet to fail and that more importantly, we are less than halfway through the removal of liquidity from the market.
Indications of weakness in demand abound, from the weak report on the Producer Price Index (PPI) to poor weekly sales figures to Wal-Mart’s (WMT) latest forecast to a slew of retailers reporting weak sales results and higher stock prices. The PPI fell a sharp 0.9%, resulting in a drop of –6.4% for the trailing twelve months. There were some special factors in that number, but one cannot wave away the year-on-year decline.
Jobless claims rose again, and even continuing claims rose. The latter is a surprise because claim benefits are starting to expire, but weekly claims levels are as yet still higher than a year ago. We should start to see sustained drops in continuing claims by the end of September or early October, though it won’t be a sign of anything good.
The rise in initial weekly claims is discouraging and also comes as a surprise to us. We aren’t believers in the V-shape recovery, but even we thought that claims should have leveled off at somewhat lower levels by now. This is an ill omen.
The only good news of the week that we could see was that the Leading Indicators rose again, rising six-tenths of a percent. There’s enough in the data to suggest that actual recession end could be called around July, but that doesn’t impress us. If the recession is deemed to have ended by a one- or two-month bounce, then it probably did end, but there’s also enough in the data to suggest that the indicators could fall again.
Looking at the U.S. economic calendar, there mightn’t be any roadblocks until next Friday. Monday is empty of news and the Case-Shiller index of housing prices on Tuesday is likely to show moderating rates of decline (a mathematical inevitability). The consumer confidence report due from the Conference Board on Tuesday is a wild card, though. The rising stock market is a tailwind for that number, but it could get overwhelmed by rising unemployment and decreasing household liquidity.
Durable goods are expected to have zigged back up in July after zagging down in June; that number is due on Wednesday. We expect a sawtooth pattern there for some time to come. New home sales are due out later that morning and the consensus is for another gain (probably exaggerated by another downward revision). We expect distressed inventory to continue to prop up the numbers.
The first GDP revision is due Thursday, and is now expected to be closer to the original estimate of a drop of (-1.5)%, rather than the (-1.0)% originally reported. Does that mean that traders have to give back the rally from that day? Don’t count on it, or on publishers issuing retractions of their earlier adoring exclamations.
Friday’s personal income and spending report constitutes the only real hurdle of the week. Consumer spending is clearly weak and the 0.3% estimate is at risk, though the cash-for-clunkers program may have saved the day. The University of Michigan releases its last August reading later that morning. If we can get by the personal income and spending report, then all things being equal, the silly season should run for another week.
StockWatcher will return in a later edition.
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